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August 2, 2011

Commodities and Portfolios: Listening Through the Noise

To begin this article, here is a little quiz (in good Jeopardy! fashion, the answer comes first):

Answer: 112%, 107%, 86%, and 79%.

Question: What are the spot returns for cotton, silver, coffee, and corn from December 2009 to May 2011?

The fact is that commodities have been on a tear for some time (the source of those return numbers, btw, is S&P GSCI spot returns.) Crude oil, for example, is up 47% over that same 18 month period while gold, everybody’s favorite commodity, has jumped 30%. Even a diversified basket of goods like the one represented by the Dow Jones-UBS Commodity Index is up 22% for the stretch.

These are outsized numbers, to be sure, but that doesn’t mean advisors shouldn’t still be considering commodities for their clients’ long-term investment portfolios. We think they should, and here are a few reasons why:

Reason No. 1: Commodities Are an Inflation Hedge Over the years, we’ve all come to appreciate commodities for their inflation hedging properties. And rightfully, so according to the statistical relationship between the DJ UBS Commodity Index versus and the Consumer Price Index (CPI) as shown in Chart 1 below.

The graph, which goes to back to the Index’s inception in January 1991, clearly shows that having exposure to a broad basket of commodities has consistently provided investors a good degree of purchasing power protection. The relatively high R-squared value (.82) indicates that the returns to commodities are, in fact, partially explained by inflation over long-term time periods. There’s no reason to believe that will change.

Reason No. 2: Commodities Are a Diversifier Just as important, commodities provide an important diversification benefit over time when paired with a portfolio of stocks and bonds. Chart 2 below shows the R-squared numbers of a blended portfolio of 60% S&P 500 Index / 40% Barclays Aggregate Index versus the DJ UBS Commodity Index over several time frames from the Index’s inception.

Clearly, exposure to commodities over the long term would have diversified a simplified portfolio of stocks and bonds.

The increasing correlation in the short term, of course, should remind us that an allocation to commodities is made for their long-term diversification benefits. While it’s reasonable to think the increase in the R-squared measure is a reflection of increased attention and asset flow from investors, it’s just as reasonable to think that condition could persist going forward.

Reason No. 3: Commodities Have Multiple Drivers of Return

The total return for a diversified basket of commodities is comprised of at least three things: each underlying commodity’s spot return, each underlying commodity’s roll yield return, and the interest earned on the underlying collateral. A look at the S&P GSCI Index, as seen in the table below, which goes back to January 2, 1970, indicates what has driven the total return of the Index over each decade from its inception.

Percentage Contribution of Total Return of S&P GSCI Index

Decade

Spot Return

Roll Yield

Interest Rate on Collateral

1970s

9.05

4.62

7.58

1980s

-1.37

2.41

9.62

1990s

-0.63

-0.53

5.05

2000s

10.16

-7.98

2.87

Source: RS Investments

What’s immediately apparent is that there is no trend or trends across the decades. Each of the contributors has their moment. There is, however, something among recent behaviors that’s worth noting: the declining contribution of roll yield to the total return.

Positive roll yield is defined to be the return a futures investor captures by

rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price. Profits, in other words, come from rolling yield in a backwardated futures market—when the futures price is below the spot price. We’re in a so-called contango market, however, which is the opposite of backwardation. More commodity futures are trading above the expected spot price. Directionally, that means traders are anticipating rising prices.

Reason No. 4: Commodity Investment Options Are Easily Available

They’re still not abundant, but the number of mutual fund options available to advisors seeking exposure to commodity or commodity-related investments is on the rise. By our count, the universe of open-end mutual fund options with at least 10 years of performance history stands at 16, with another 53 that have a more limited trading history (see Chart 3 for additional details). As more investors seek to diversify their portfolios, we’ve no doubt that mutual fund companies will be launching new and differentiating fund options.

There are two primary differentiating factors among the commodity investment options available today—active versus passive and direct versus indirect. The PIMCO Commodity Real Return fund (PCRIX), for example, is passively managed to the DJ UBS Index, with the collateral being managed by Mirih Wohar, the lead manager on PIMCO’s suite of Real Return funds. RS Global Natural Resources (RSRNX), on the other hand, takes a private equity approach to buying commodity producers and owning well-managed companies that can earn above their cost of capital. Both approaches work, and both funds are worth consideration in our view.

The Conclusion on Commodities The bottom line is that all the chatter around the commodity market these days is not at all surprising. We’ve just witnessed an extraordinary run-up in prices. But beyond the entry point, we’re here to suggest that, noise aside, not much has changed with regard to the long-term return potential and the diversification benefits of the asset class.

Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.

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